Moment at SEBI towards principles based regulation

The new principles-based SEBI regulations

The new SEBI regulations on advertisement show the shift towards principles-based regulation. For example a regulation reads:

In audio-visual media based advertisements, the standard warning in visual and accompanying voice over reiteration shall be audible in a clear and understandable manner. For example, in standard warning both the visual and the voice over reiteration containing 14 words running for at least 5 seconds may be considered as clear and understandable.

Instead of mandating that the warning should be at least 5 seconds long, it has stated that that it must be clear and audible. The 14 words in 5 seconds is now not a legal requirement: it is only an illustration of how the principle can be satisfied.

On valuation, the new regulations say:

The valuation of investments shall be based on the principles of fair valuation i.e. valuation shall be reflective of the realizable value of the securities/assets. The valuation shall be done in good faith and in true and fair manner through appropriate valuation policies and procedures.

This regulation recognises that there are many different types of assets a mutual fund may acquire, stocks, securitisation papers, derivatives, bonds, etc. Each of them may have different forms of valuation. More importantly the list of assets mutual funds may buy is not exhaustive: as the Indian financial markets develop there may be other instruments that mutual funds may purchase. The principle however, will hold true for different assets and valuation methods. The objective of the regulation is to ensure that the investors get a fair picture of the assets their fund holds.

Assessment

We do not know what forms of media the mutual funds will use in the future: billboards will go 3D, holograms will be used, mobile phones will explode with targeted advertising. Mutual funds will also invest in new financial instruments in global markets. As long as the provide warnings in a clear and understandable manner and value their assets in a fair and truthful system, the will be compliant with SEBI regulations and can innovate freely.

Principles based regulations have two major advantages over rules based system:

1. The regulations require the regulated to strive towards an outcome and not mechanistic compliance.
2. The regulations allow for innovation to be absorbed quickly by the industry as long as they meet the objective of the regulation. Imagine if the Contract Act had specified that all acceptance of contracts should be done by letters. All the innovation of e-commerce, mobile telephony based commerce, telephonic negotiation and trading would have been illegal till the statute was amended. This would have required Indian law-makers to constantly update the Contract Act.

Moving to a principles based system is a crucial step forward, away from the command and control mindset that many regulators suffer from. Instead of prohibiting malpractices, all too often, laws in India micro-manage the regulated business. This is a recipe for stagnation.

However, principles based financial regulation also has costs. Rules are black and white - there is legal certainty. With principles based regulation, the precise nature of a government response to a new idea by the private sector is less predictable.

More complex behaviours are, then, required of the regulator. More litigation will arise. This will impose a greater burden on staff in regulators, courts and law firms. They will need to understand principles (and their underlying drafting intent), alongside practical knowledge about how the real world works, so as to be able to intelligently apply the principles. This requires a great deal of understanding of technology, business and regulatory objectives. Moving towards a principles based system requires commensurate strengthening of staff capabilities at SEBI, the Securities Appellate Tribunal (SAT), and the Supreme Court

Transactions between banks in bad assets: An interesting legal drama....

The much awaited decision of the Supreme Court in the matter of ICICI v. Official Liquidator of A.P.S. Star Industries is now available. The case had come as an appeal against a decision of the Gujarat High Court which invalidated transfer of Non-Performing Assets between banks. The decisions of the High Court and the Supreme Court are important in illuminating the legal foundations of Indian finance.

Background

Various borrowers owed a total of Rs. 52.45 crores to ICICI (Amongst which one of the borrowers was M/s A.P.S. Industries). These loans were classified as Non-Performing Assets (NPAs) by ICICI. ICICI transferred these NPAs to Kotak Mahindra on "as is where is" basis by way of a Deed of Assignment. Consequently, the Kotak Mahindra became the full and absolute owner of the debts and as such the entity legally entitled to receive the repayments of debts.

M/s A.P.S. Star Industries subsequently went into liquidation. Kotak Mahindra filed a Company Application in the winding up proceedings of A.P.S. Star, praying for being substituted in the place of ICICI (As it was now the owner of the debt). Though the transfer document between ICICI and Kotak was held to be valid the company court held that such transfers of NPAs was not allowed under the Banking Regulation Act of 1949 (BR Act).

The High Court ruling

On appeal a Division Bench of the Gujarat High Court upheld the observation of the Company Court on the following main grounds:

• Section 6 of BR Act gives and exhaustive list of activities a bank is allowed to carry out and sale of NPAs is not present in the list.
• Since banks prohibited from trading activities (See section 8 of the BR Act) and the sale of NPAs is essentially trading, such transfer was invalid.
• Such trading of NPAs would mean transfer of NPA from one banks balance sheet to another without any resolution and therefore against the health of the banking industry.
• Since individual loans were lumped together and bought there was no way to ascertain the value of individual loans and the amount recovered from them. This made such loans essentially speculative trading.
• Since the customer is forced to transact with another bank now and also he is being lumped with other loans, this amounts to violation of the relationship between the bank and the customer.
• By legislating s.5 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act), the Parliament has made it clear that only securitisation companies can buy NPAs and not banks.

The Supreme Court ruling

To much relief of the banks, the Apex Court has set aside the impugned judgment and order, laying down the following important legal propositions:

• Section 6(1) of the BR Act is a general provision and enumerates topics as fields in which banks can carry on their business. This is the core banking business. However, RBI, being the regulator, under Section 21 and 35A can issue directions having statutory force, laying down parameters enabling banks to expand their business. Such parameters will define `banking business'. (¶ 13)
• RBI, by issuing guidelines authorized banks to deal in NPAs and such guidelines cannot be held ultra vires of the Act. Such guidelines have statutory force and hence inter se transfer of NPAs between banks is permissible. (¶ 14)
• The 2005 guidelines of RBI are not to eliminate NPAs but to restructure the same. Such restructuring cannot be treated as trading. (¶ 15)
• The SARFAESI Act was enacted enabling specified SPVs to buy the NPAs from the banks. However, from that it does not follow that banks cannot transfer their own assets. (¶ 21)

Deeper issues

While the judgment seems to set law in the correct direction, it raises other questions. The borrowers had argued that the only legal way of transferring financial assets is under Section 5 of the SARFAESI Act which reads:

``Notwithstanding anything contained in any agreement or any other law for the time being in force, any securitisation company or reconstruction company may acquire financial assets of any bank/FI..''

However, Chief Justice Kapadia, while writing the judgment observed in ¶ 21 that `the SARFESI Act 2002 was enacted enabling specified SPVs to buy the NPAs from the banks'. As discussed, this statement seems to be missing out that even good debts which are not NPAs can be bought by those SPVs under s. 5 of the SARFESI Act. May be this is an inadvertent omission, but it is interesting to observe that Justice Kapadia previously also in Transcore v. Union of India (2008) 1 SCC 125 observed (in ¶ 20) that `it is only when these assets in the hands of the bank/FI becomes sub-standard, doubtful or loss then the account or asset becomes classifiable as a NPA and it is only then that the NPA Act comes into operation'. The same is reiterated in ¶ 30. Clearly, these observations do not quite fit with the literal interpretation of s. 5. Probably the pedantic have got another question lingering in their minds: `Can a bank/financial institution sell off a debt, which is not a NPA, to a securitisation/assets reconstruction company?'


One also asks what remains of Section 6 of the BR Act which describes what activities banks can take part in. Justice Kapadia states `In other words, the 1949 Act allows banking companies to undertake activities and businesses as long as they do not attract prohibitions and restrictions like those contained in Sections 8 and 9'. This would mean that while the legislature drafted Section 6, this is irrelevant today. He also goes on to state `Thus, RBI is empowered to enact a policy which would enable banking companies to engage in activities in addition to core banking process it defines as to what constitutes ``banking business''.' 


This implies that there is unfettered power with RBI to define what business banks can take part in. This is unusual as it seems that there are no parliamentary control over what banking business can imply. Unlike `securities' which is defined under the Securities Contract Regulation Act by Parliament and only the central government may modify it by notification, (and therefore no regulator is free to define any instrument as a security and regulate it) `banking' seems to be under a Henry VII clause for RBI. There seems to be no provision under the BR Act allowing the central government (let alone the RBI) to change the definition of `banking'. The judgment however empowers RBI to do so without and rider or guidelines. This also goes against the principles of interpreting laws as it makes all provisions in Section 6(a) to (o) irrelevant.

Conclusion

The judgment reveals the state of financial laws in the country which are unable to guide the judiciary unambiguously. The judicial interpretations also seem to alter the nature of the laws and the drift between the letter of the law and its meaning continues to increase.

Qualified Foreign Investors (QFIS) Allowed to Directly Invest in Indian Equity Market; Scheme to Help Increase the Depth of the Indian Market and in Combating Volatility Beside Increasing Foreign Inflows into the County

In a major policy decision, the Central Government has decided to allow Qualified Foreign Investors (QFIs) to directly invest in Indian equity market in order to widen the class of investors, attract more foreign funds, and reduce market volatility and to deepen the Indian capital market. QFIs have been already permitted to have direct access to Indian Mutual Funds schemes pursuant to the Budget announcement 2011-12. Today’s decision is a next logical step in the direction.

Foreign Capital inflows to India have significantly grown in importance over the years. These flows have been influenced by strong domestic fundamentals and buoyant yields reflecting robust corporate sector performance.

In the present arrangement relating to foreign portfolio investments, only FIIs/sub-accounts and NRIs are allowed to directly invest in Indian equity market. In this arrangement, a large number of Qualified Foreign Investors (QFIs), in particular, a large set of diversified individual foreign nationals who are desirous of investing in Indian equity market do not have direct access to Indian equity market. In the absence of availability of direct route, many QFIs find difficulties in investing in Indian equity market.

As a first step in this direction, QFIs have been permitted direct access to Indian Mutual Funds schemes pursuant to the Budget announcement 2011-12. As a next logical step, it has now been decided to allow QFIs to directly invest in Indian equity market in order to widen the class of investors, attract more foreign funds, and reduce market volatility and to deepen the Indian capital market.

The QFIs shall include individuals, groups or associations, resident in a foreign country which is compliant with FATF and that is a signatory to IOSCO’s multilateral MoU. QFIs do not include FII/sub-accounts.

Salient Features of the Scheme:

· RBI would grant general permission to QFIs for investment under Portfolio Investment Scheme (PIS) route similar to FIIs.

· The individual and aggregate investment limit for QFIs shall be 5% and 10% respectively of the paid up capital of Indian company. These limits shall be over and above the FII and NRI investment ceilings prescribed under the PIS route for foreign investment in India.

· QFIs shall be allowed to invest through SEBI registered Qualified Depository Participant (DP). A QFI shall open only one demat account and a trading account with any of the qualified DP. The QFI shall make purchase and sale of equities through that DP only.

· DP shall ensure that QFIs meet all KYC and other regulatory requirements, as per the relevant regulations issued by SEBI from time to time. QFIs shall remit money through normal banking channel in any permitted currency (freely convertible) directly to the single rupee pool bank account of the DP maintained with a designated AD category - I bank. Upon receipt of instructions from QFI, DP shall carry out the transactions (purchase/sale of equity).

· DP shall be responsible for deduction of applicable tax at source out of the redemption proceeds before making redemption payments to QFIs.

· Risk management, margins and taxation on such trades by QFIs may be on lines similar to the facility available to the other investors.

The scheme is expected to help increase the depth of the Indian market and in combating volatility beside increasing foreign inflows into the county.

SEBI and RBI are expected to issue relevant circulars to operationalise the scheme by January 15, 2012.(as per SEBI GUIDELINE)

Stock lending coming to life ( Financial Express)

While India has a world class equities trading ecosystem, one of the last missing building blocks is a mechanism to borrow shares. Stock lending is important because it will improve the pricing of stock futures, and because it will enable expression of bearish views about non-derivatives stocks. A stock lending mechanism has been under development for a decade. In 2010, there seems to finally be some traction in this. If this works out, then one of the last missing pieces of the equity ecosystem would fall into place.

Divergent views of an array of participants are the essence of finance. If a person feels optimistic about a stock, he can borrow money and buy shares. What about the pessimist? When a share price is Rs.100, a pessimist borrows shares and sells them on the market. He is obliged to return the shares at a later date. If the pessimist is right, the share price goes down to (say) Rs.90. He then buys the shares back at Rs.90 and returns them, for a profit of Rs.10.

The ability to borrow shares is thus essential to a free and fair market: Just as optimists can borrow money, pessimists should be able to borrow shares. While this is the right way to think about thousands of listed firms in India, there is a privileged group of 200 firms who are different. They have stock futures trading. India is unusual by world standards in having achieved success with stock futures at NSE. Stock futures are cash settled, thus giving true symmetry between the optimist (who would buy the stock futures) and the pessimist (who would sell the stock futures).

While stock lending is not important for a healthy and balanced speculative price discovery to come about for these 200 stocks, there is still a vital role for it, in the process of stock futures arbitrage. Derivatives pricing is done by arbitrage. The futures price should reflect an interest cost of carry over the spot price. If the futures price on the market is too high, then arbitrageurs step in, who buy an equal quantity of shares on the spot market and sell the futures. They make a profit while taking no risk, and perform the socially beneficial function of pushing prices back to sanity.

But what happens if the futures price is too low? The arbitrage strategy then requires buying the futures (where the price is too cheap), and simultaneously selling an equal quantity of shares on the spot market. But what if the person doing this arbitrage does not own those shares? He needs to be able to borrow them. Hence, a stock lending mechanism fosters pricing efficiency for the stock futures, by connecting shares (in the portfolios of lenders) with the arbitrageur. Indeed, without a stock lending mechanism, a sharp decline in the stock futures price is hard to correct.

In the international experience, stock lending is done on a bilateral basis. The borrower and lender meet each other and undertake the lending. This leads to trouble when the borrower defaults, in which case the lender stands to lose his shares. In India, a unique path was chosen by SEBI: that of requiring a counterparty guarantee of the clearing corporation, and of having a transparent screen-based system for borrowing.

For many years, this did not work out. There have been times when the present author has despaired of making this work and recommended that we drop down to bilateral mechanisms, as is done in the West. In 2009 and 2010, finally, it appears that the problems are being resolved. SEBI revised its rules about the stock lending mechanism. In June, NSE's clearing corporation (NSCC) implemented a screen based matching platform and a full counterparty guarantee, reflecting these new rules.

In recent weeks, this has started exhibiting some traction. Over 10 weeks, lending worth Rs.300 crore has taken place, with an average of Rs.5.5 crore a day. A total lending fee of Rs.64 lakh was paid. While these numbers are puny, they are a lot better than zero. They suggest that basic design mistakes are absent. With further debugging, there is a potential for fairly big numbers to rapidly come about. Every investor who has shares sleeping in a depository account now has an opportunity to make a little revenue by lending out these shares.

At present, there are two key constraints. First, institutional investors are absent on the lending side. For any investor, earning a little additional revenue by stock lending is a free lunch, since NSCC guarantees the return of shares thus eliminating credit risk. The constraints which hold back mutual funds, FIIs, banks and insurance companies from lending shares need to be removed.

Secondly, for firms lacking stock futures trading, stock lending is of critical importance in enabling the expression of negative views. Absent stock lending, stock prices have a positive bias since optimists can take positions while pessimists cannot. Hence, the scope of stock lending needs to be broadened beyond the derivatives list.

SEBI Changes in 2012.........

A. As  a New Year gift to the Companies that are not meeting the Minimum Public Holding requirement, SEBI has at its Board Meeting held on 3rd January 2012 decided to introduce the following additional methods, for the purpose of compliance with the provisions of SCRR with regard to the Minimum Public Shareholding to be maintained in any listed company:


1. Institutional Placement Programme (IPP); and


2. Offer for sale of shares through stock exchanges


Both the above mentioned methods have certain salient features/ pre prequisites and need to be followed in compliance therewith. Under both the options, caps have been specified, in terms of the Issue Size, limits of dilution, categories of allottees/ transferees, procedure for allotment etc.


The highlights of IPP Method are as follows:


Public shareholding can be increased by 10% or such lesser percentage as is required to comply with the minimum public shareholding requirement.
Shares can be sold only to qualified institutional buyers, with a reservation of minimum 25% to mutual funds and insurance companies.
Issuer shall announce an indicative floor price or price band atleast one day prior to the opening of the offer.
The aggregate demand schedule shall be displayed by stock exchanges.
There shall be atleast 10 allottees in every IPP issuance. No single investor shall receive allotment for more than 25% of the offer size.
The allotment of shares may be made on price priority, proportionate or on pre- specified criteria which has to be disclosed in advance in the prospectus and cannot be changed subsequently.


The highlights of Offer of shares through stock exchanges are as follows:


A separate window shall be offered by the Stock Exchange.
The offer shall be for atleast 1% of the paid-up capital of the company, subject to minimum of Rs. 25 crores.
Only the promoter/ promoter group of companies which are active /eligible for trading would be permitted to offer their shares for sale.
Every bid/buy order would be required to be backed by 100% upfront cash margin. The settlement shall be through exchange clearing mechanism.
Allotment would be done either on price priority or clearing price basis proportionately and would be overseen by the exchanges.


Further, it has also been decided that Offer for sale through the stock exchanges method can, apart from being used for compliance with minimum shareholding requirements, also be used by the promoters of top 100 Companies (based on average market capitalization) for sale of their stake.


To recapitulate, SEBI had vide its Circular dated 16th December 2010, mandated that for the purpose of compliance of Cl 40 A of Listing Agreement, listed companies could have resorted to either issuance of shares to public through prospectus or offer for sale of shares held by promoters to public through prospectus or sale of shares held by promoters through the secondary market, with the prior approval of the Specified Stock Exchange, within the timelines specified by Ministry of Finance.


This move for allowing the above 2 additional methods shall prove Industry friendly in meeting with the Minimum Public Shareholding requirements in case of listed companies.


B. Further, SEBI has also decided to make the following amendments in the SEBI Buyback Regulations:


Procedure for acceptance of shares in buy back through tender offer: The company shall announce ratio of buyback as is done in the case of rights issues and fix a record date for determination of entitlements as per shareholding on record date. While the shareholders will be free to tender over and above their entitlement, acceptance of shares shall first be based on entitlement of each shareholder and if any shares are still left to be bought back, acceptance of additional shares tendered over and above the entitlement shall be in proportion to the excess shares tendered by the shareholder.
“Record Date” in lieu of Specified Date.
Review of requirement of issuing Public Notice and Public Announcement: The Public Announcement shall be published within two working days from the date of Board or Shareholders resolution, as the case may be.
Rationalisation of timelines in buyback through tender offer: It has been decided to revise the time lines for various activities involved in the buyback process.


SEBI has also issued a Circular bearing no. CIR/IMD/FIIC/1/2012 dated 3rd January 2012, with respect to the investment limits of FIIs in Government debts and Corporate debts, whereby it has withdrawn the facility of re-investment and now re-investment period shall not be allowed for all new allocations of debt limit to FIIs/sub-accounts.

With global market turmoil & weak rupee! Will Gold shine in 2012?

Gold's spectacular sprint has been cut short by a speed bump in the past few weeks. From an all-time high of over $1,900 an ounce (Rs35,332 per 10 gm at $1: Rs52.72) in September, the price of the precious metal fell to under $1,590 an ounce (Rs29,520 per 10 gm) in mid-December. The question worrying investors now is whether this obstacle will lead gold prices to trip and fall, or will they touch even higher peaks?

There is no doubt that 2011 was the golden year; gold prices rose by 32.6%, while the Sensex fell by 25.2% (see graphic). Even silver performed better by delivering 11.4% returns. But will these metals continue to outshine in the new year? Experts are divided about how gold will move in 2012. While some believe that the prices will cross $2,000 an ounce, others argue that these will move in the opposite direction and may drop to as low as $1,450.

Kunal Shah, head, commodity research, Nirmal Bang, is among the latter. "There are two major reasons why gold will lose its sheen. One, the US economic reports have been encouraging in the previous quarter, so the dollar is likely to strengthen. Two, inflation is expected to moderate. I see gold trading at $1,300-1,400 an ounce in the coming year. Any major rally from here will be a good opportunity to book profits." 


The global economic turmoil may be a stimulant as well as a dampener for gold prices. While the metal is seen as a hedge against inflation, in the current scenario, there is fear that deflation may be more likely. In fact, despite the recent warning by rating agency Fitch that it may downgrade France and six other Eurozone countries, gold prices remained lacklustre.

The opposing school of thought believes that as the factors that pushed gold prices this year-Eurozone debt crisis, negative real interest rates, inflation and debasement of fiat currencies-will continue to have a strong impact in 2012, the prices will move even higher. 


Major international banks have predicted that gold prices will rise by 13-28% (above $1,595 an ounce), which means that they will range from $1,810-2,050 an ounce. According to Goldman Sachs, central banks may buy 400-600 tonnes of gold in 2012, which could push up the price of gold. 


Other analysts are also bullish on gold. Says Renisha Chainani, manager, commodities research, with Edelweiss Comtrade: "There is more than a 50% chance that gold prices will touch the $2,000 mark in the second half of 2012. However, it will not be a one-way rally and volatility may be high, so the price could range from $1,500-2,000 next year." She advises investors to allocate no more than 10% of their portfolio to gold. 


Though prices may fluctuate in the international market, the variance in India may be low because of depressed demand between 16 December and 14 January. The demand will pick up when the wedding season starts and gold is bought irrespective of the price. Another reason is that though prices may decline globally, the weakening rupee will keep them high in India. Says Thomas J Muthoot, MD, Muthoot Finance: "The global gold prices have slid almost 7% in the past month, but the falling rupee has contained the fall to 2.5% in India."

Source:Economic Times.

Goods and Service Tax (GST) : A weapon against corruption.............

Over the last few months, there has been a national debate on corruption and different ways of tackling it. Fortunately, this time, there seems to be a sense of purpose in the discussions rather than a thought around 'learning to live with it'.

Amid the flurry of activities that have taken place, the discussions around few other important and potentially-radical reforms such as implementation of the goods and services tax (GST) have taken a back seat, though the same can also be one of the effective ways of dealing with corruption.

First, the GST would disincentivise growth of parallel economy. Given the multi-layered tax system with a narrow base of 'pass-through' taxes, the incentive to keep the transactions 'outside the books' is significant, particularly in some segments of industry. For example, if a real estate company were to purchase cement, steel, etc, from a supplier without recording the transaction, effective saving could be 20-25% (comprising 10.3% excise duty and 4-15% VAT).

This would usually trigger other areas of evasion - typically at supplier's end - such as power, income tax and other statutory levies. Now, if the sector is within the ambit of GST wherein sale or leasing of residential or commercial property attracts GST, then input GST paid would be allowed as a set-off that would obviate a need for the purchaser to look out for suppliers who would sell on cash basis. Once the 'cash' component of the economy reduces, there would be quick and tangible impact on level of corruption.

The tax system is characterised by state-specific variations in terms of VAT rates of commodities, frequent changes or introduction of new levies and a large list of tax-exempt goods and transactions. While there are many reasons, one of the main reasons is the large discretionary powers vested with the governmental authorities in this regard.

As GST stems from the basic requirement of uniform and stable tax policies, the element of discretion reduces significantly in terms of powers to make an exception or deviation from the model rate structure as well as the incentives offered under legislation. Less discretion would often mean less corruption.

Another key feature would be heavy reliance of GST on technology for ensuring compliance. Most applications and tax filings are likely to be automated that would mean lesser physical touch points between taxpayers and authorities.

Also, e-filings would ensure there is no possibility of back-dating a document, furnishing incomplete details, or changing documents or information at a later stage without following the prescribed procedure under law. As there would be limited avenues to circumvent laws, there would be limited incentive to engage in corrupt practices.

The ability of implementing agencies to use the vast amount of data and information available would also be enormous. Taxpayers would have PAN-based GST registration, which would enable the authorities to periodically cross-check declarations made by taxpayers under GST with other laws, such as income tax, company law, etc.

Any discrepancies can be detected and, hence, room for manoeuvring different tax authorities - at state and central level - would become increasingly difficult. The government database would also be more comprehensive that can also be then sliced and diced in different ways in terms of location, industry, consumption pattern and so on. This would enable efficient application of audit tools to find instances of discrepancies and possible areas of evasion and corruption. (Economic Times)